Talking Markets with Jeffrey Sherman and David Rosenberg at the AKG Museum

Deputy Chief Investment Officer Jeffrey Sherman interviews David Rosenberg, President and Founder of Rosenberg Research, covering, among other topics, Mr. Rosenberg’s outlook on a U.S. recession, his view that market pricing is missing the likelihood of the Federal Reserve being forced to ease in 2024 and the resemblance of the current stock market as tracked by the S&P 500 Index to 2007 and 1987. Their talk took place Oct. 5, 2023, before an audience at the Buffalo AKG Art Museum in Buffalo, New York.

Mr. Sherman begins (1:47) by asking Mr. Rosenberg for his insights into the cause behind the repricing of financial markets over August and September, particularly in fixed income. “We’ve had a one- or two-standard deviation event in the bond market in the past several months. And something’s taken the market by surprise,” Mr. Rosenberg says. The driver, he says, was not changes in inflation or growth expectations or fiscal policy. The driver was the Fed. While the Federal Open Market Committee stood pat Sept. 20, “they may as well have raised rates because the guidance was so hawkish; they should have done 50 basis points.” While the front end of the Treasury curve “was never battling the Fed, it was the back end of the curve that was battling the Fed.” In the reset of Fed expectations, the Fed finally “got the bond market to break, and then everything priced off the bond market is breaking at the same time.”

Turning to the U.S. economy and his recession outlook (7:23), Mr. Rosenberg says the stimulus is about to run out for the consumer, who accounts for 70% of GDP. “The average American household has four credit cards now,” he notes. “I guess, one for the husband, one for the wife, one for the kid and one for the dog. It’s rather incredible. It’s unprecedented, actually, but it financed 20% of consumer spending growth this year, just credit card usage. It’s not been organic income based despite what the Wall Street gurus might tell you.” He cites higher delinquencies on consumer credit and an anemic household savings rate of 4% vs. 8% pre-COVID-19 pandemic. He also notes that $2.2 trillion in Biden administration stimulus checks went completely into consumer spending rather than splitting, as in the past, between spending and saving.

While large corporations have locked in term financing and so have not faced immediate pressure of higher borrowing costs, Mr. Sherman turns to small businesses (11:31), the source of most job creation in the U.S. “Where do they borrow today? They don’t go to the capital markets,” Mr. Sherman says. “They get socked with something called the prime rate. We all know prime is 300 over Fed Funds, right? So the base rate starts at 8½%. How long can we maintain this economy?” Mr. Rosenberg points to weakness in the small-cap Russell 2000 Index and their lenders, the regional banks. “That’s telling you something about how the regional banks are going to be restricting credit, and that’s going to have a massive impact, a much bigger impact on small business. It’s not just the cost of credit, it’s also the availability of credit.” Ultimately, that will trace through “to employment, and employment’s always last man standing as we go into recession.”

Mr. Rosenberg does acknowledge an industrial construction boom (13:22) in the U.S., thanks to the CHIPS and Science Act, which is providing federal funding to increase research and manufacturing of semiconductors in the country. “We’re building all these facilities, but there’s no production. They’re obviously hoping we’re going to build these facilities, and then the U.S. will become a semiconductor producer again. I think these facilities will get mothballed, but the hope is that this will help get Biden re-elected next year. So, I think that was more political than anything else, and maybe another way to screw China.”

Asked by Mr. Sherman to discuss the mind-set at the Fed with respect to inflation (15:15), Mr. Rosenberg replies, “What they want to see is slack emerge in the labor market. In other words, what they want to see is the participation rate go up. They want to see the unemployment rate go up. And that’ll make them very comfortable.” Ultimately, Mr. Rosenberg believes the Fed will be compelled to pivot (19:33). “I’m sticking with the call that there at this stage there is not enough Fed easing priced in next year. I think that people who threw away caution to the wind and they threw their recession forecast in the wastepaper bucket I think is a big mistake. There’s a difference between saying the recession has been delayed, but to say that it’s been derailed is then to tell everybody in this room, guess what? Guess what? The business cycle’s been repealed, and interest rates don’t matter, and there’s no such thing as policy lags. None of that is true. They all exist.”

Mr. Sherman (21:09) asks, “What breaks? Because the Fed is only going to acquiesce once there’s a break.” Mr. Rosenberg says, “Everybody in the room should be really focused on the stock market. It has a sense of ’07, but it also has a bit of a sense of ’87. Oil shock, dollar shock, rate shock: Well, we have all three. But there’s also some big liquidity issues as well, especially in the Treasury market.” In the wake of the surge in borrowing costs for small to medium-sized companies, capital spending projects are being shelved. To avoid losing hard-to-recover workers, companies are resorting to furloughs, but eventually layoffs will come. But in terms of the sequence of events, the financial accidents will occur after the start of recession, not before it.

Ultimately, recessions, Mr. Rosenberg argues (27:58), are not caused by debt service; they are caused by declining GDP, which is the absence of new spending. “The recession is about the fact that at this new level of interest rates, you cannot afford to buy a home. Despite the fact that everybody locked in their mortgage, housing starts are collapsing again because we have an 8% mortgage rate…. New spending is going down because of interest rates. Capital spending is going down because of interest rates.” As in 2007, when the recession began later than expected because the consumer was supported by cash-out mortgage equity withdrawals, consumer spending in the current cycle, he says, has been fueled by “the last vestige of the excess savings.”